There seems to be some confusion over what the Goldman Sachs-SEC lawsuit is about. This isn’t just about the fact that Goldman sold its clients some bonds and then later bet against them. In my view, that wouldn’t be so bad. Goldman would be playing two independent roles in that story — broker on one side, trader on the other — and following independent strategies to hedge against market risk. Micromanaging investment banks’ hedging strategies could have all sorts of undesirable unintended consequences.

But the fraud alleged here is more serious than that, and it concerns the way Goldman structured and sold a particular bond, a structured product known as a Collateralized Debt Obligation (CDO). These products are not like ordinary stocks and bonds, which are pretty straightforward investments. They’re made up of the cash flows of a variety of underlying assets — in this case, pools of mortgages. There was a heavy demand for these products during the housing boom, and investment banks such as Goldman were under pressure to keep churning them out. The charge against Goldman is that at least one of these products, a CDO called Abacus 2007-AC1, was built to fail.

The outside consultant Goldman hired to select which mortgages would go into the CDO, a hedge-fund manager named John Paulson, is now known as one of the most famous housing shorts ever — he made an estimated $3.7 billion betting that these kinds of mortgage-backed bonds would go bad. So it is pretty disturbing that Goldman would bring him in as an “independent manager” to help it construct a CDO and not disclose this fact to the CDO’s buyers.

It would be like holding a basketball game, letting a Vegas sharp secretly select the players on one of the teams, and then presenting it to the public as a fair game. The sharp would have an incentive to select the worst players for his team and then bet against it. According to the SEC, that is exactly what Paulson and Goldman did

Based on the scan, we have not seen any screaming smoking guns. There is certainly evidence that Goldman and Tourre said one thing internally and another externally. It also appears that the information that was omitted in the external marketing materials would likely have been of interest to investors.

That’s not proof of fraud, but, as represented by the SEC, it looks bad. Goldman will want to make it go away (read: out of the headlines) as quickly as it can.

Importantly, this is NOT a criminal indictment. It is a civil lawsuit. The SEC and Justice Department usually work together, so the absence of a criminal charge suggests that the Justice Department did not feel criminal charges were warranted.

So here’s what’s likely to happen to both parties:

Goldman Sachs will have to write a big check, and then it will be fine: Goldman will likely say the charges have no merit and then, in a month or two, settle with the SEC for a few hundred million dollars (chicken feed). Goldman will then defend itself against the civil lawsuits that arise from this and probably settle those as well. There may also be follow-on lawsuits for other CDOs and products Goldman created. Those, too, will likely be settled or dismissed. Bottom line: This will cost Goldman some money, but not enough to matter to investors.

Fabrice Tourre will be placed on administrative leave or fired (a.k.a., thrown under the bus). He will then spend the next couple of years testifying in this and other follow-on civil lawsuits. The SEC will probably demand a cash settlement from him, too, and boot him out of the industry. Based on our scan of the allegations, Tourre was involved in every aspect of the structuring and marketing of the CDO in question. The complaint includes snippets of communications in which Tourre describes the CDO one way internally and another way externally. Again, this is not proof of fraud, but, at least as represented by the SEC, it looks bad. Tourre will likely want to fight the charges, especially if he thinks they’re b.s., but it will be too risky and expensive for him to do so, so he’ll likely settle. Having made such public allegations, the SEC will make sure that any settlement produces an appropriately tough-looking headline (thus the fine and industry dismissal).

With this suit, the SEC has finally uncovered the real scandal behind the Abacus deals. The NYT tried, back in December, but it didn’t quite get to the nub of the story — although Paulson was mentioned in the NYT story as someone who was generally short the subprime market, there was no indication that he played any role in structuring the deals. Neither was there any mention of ACA.

The scandal here is not that Goldman was short the subprime market at the same time as marketing the Abacus deal. The scandal is that Goldman sold the contents of Abacus as being handpicked by managers at ACA when in fact it was handpicked by Paulson; and that it told ACA that Paulson had a long position in the deal when in fact he was entirely short.

Goldman Sachs has lost more than $10 billion in market capitalization today, in the wake of these revelations. Good. It can go long markets and it can go short markets. But it can’t lie to its clients. That’s well beyond the pale.

Goldman, Sachs is getting busted, finally, for what to me is one of the most devious and brilliant crimes of the last decade.

I can’t get into this too much because I have other material coming out about it. But the upshot of it is that GS teamed up with a hedgie named John Paulson (no relation) to make the biggest ball of subprime shit they could, got short of it by credit-default-swapping it, then roped third parties into buying it. It’s kind of awesome in a way, and I’m sure it was fun while it lasted.

But now I’m reminded of the scene in Goodfellas when the cops bust Henry :

One wants to be cautious about saying that Goldman Sachs is definitely guilty. Financial crises produce immense political pressure for securities regulators and attorneys general to go head-hunting, and the cases often turn out to be weaker than they seem once the defense gets a chance to speak. The case against two Bear Stearns hedge fund managers, for example, turned out to hinge on horrific-sounding quotes that had very clearly been ripped out of a context that totally changed the implications. Which just goes to show how heavy the pressure is on prosecutors to make these cases.

But it certainly sounds as if the SEC has the goods here. Felix Salmon has gone through the pitchbook, and pronounces it free of any indication that a third party with a strong economic interest in the transaction was picking the securities to be included. I will be interested to hear the defense rebuttal. It should, at the very least, be entertaining.

Was anyone hurt by it? That’s less clear–at that point, the market still had a bit of froth left, and people might well have bought the securities if Paulson’s interest had been disclosed. But that doesn’t matter. It’s hard to imagine anyone making an argument that Goldman didn’t have an obligation to disclose this information–and the fact that they failed to disclose seems to indicate that Goldman, at least, thought that the information would adversely impact the sale price.

I suspect this case will get a lot of public traction. At this point, what galls people is not so much the stupid behavior that led to the bailouts, but the blatant self-dealing that seems to have gone on. Unfortnately, much of that self-dealing is not actually illegal . . . so when we find an example that is legally actionable, the public and the court system are bound to jump on it with both feet.

So there you have it. Finally, the financial crisis gets its first major fraud case. Investment banks created complex securities that increased the risks of in the financial system. Most then held on to the securities because they didn’t know what they had. Goldman instead came up with an elaborate scheme to lay off the risk on unsuspecting investors. Either way, Uncle Sam had to come in a clean up the mess. As the SEC says, in selling something they knew was worthless, Goldman was no different from the medicine man of old. It’s a fraud as old as time.

The first question was who was damaged here. The answer is all of us. First of all, the investors who bought the securities lost about $50 billion on them $1 billion. (That’s the figure for the deal in question by the SEC. But I believe if you figure in all the deals synthetic deals that Goldman set up the investor loss is much larger.) Those investors were mostly pension funds. Second, Goldman insured these purposefully useless mortgage bonds with AIG. So all of us, taxpayers that is, had to pay up for those losses when AIG had to be bailed out. So this suit is really just a case of the government trying to get its money back from Goldman. That’s something we should see more of.

Two more questions: Does this end Blankfein’s reign as head of Goldman? I think so. It’s a big deal for an investment bank to be charged with securities fraud. And it is not just a coincidence that Goldman would get hit with a fraud case when Blankfein was CEO. Even though he is not named in the complaint, Blankfein is to blame. He pushed the firm to become less of an investment bank and more of a trading behemoth. And this is the result: A brilliant trade that was so brilliant the Goldman people forgot that it also might be fraud.

Last: So are hedge funds more to blame in the financial crisis than we thought? It certainly looks that way. When the hedge funds went before Congress a year or so ago, they were praised–Paulson included. Now it looks like Paulson masterminded a trade that cost the government tens of billions of dollars. I would hope his next Congressional meeting will be less pleasant.

The Goldman Sachs Group, Inc. (NYSE: GS) responds to a complaint filed by the SEC today.

The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.

The Goldman Sachs Group, Inc. is a leading global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals. Founded in 1869, the firm is headquartered in New York and maintains offices in London, Frankfurt, Tokyo, Hong Kong and other major financial centers around the world.